10.1 Characteristics of Bonds
3 min read•june 18, 2024
Bonds are debt instruments that play a crucial role in finance. They come with key characteristics like , , and . Understanding these features is essential for grasping how bonds function and their place in investment portfolios.
Different types of bonds, such as government, corporate, and municipal, offer varying levels of risk and return. The inverse relationship between bond prices and yields is fundamental to bond investing. Special features like callable and add complexity to the bond market.
Bond Fundamentals
Key characteristics of bonds
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- ( or ) represents the amount the bondholder will receive at maturity, typically $1,000 per bond
- is the annual interest rate paid on the bond's par value, expressed as a percentage, and determines the periodic coupon payments
- is calculated by multiplying the coupon rate by the par value
- Maturity date marks the end of the bond's life when the bond issuer repays the par value to the bondholder, and can range from a few months to several decades
- measures a bond's price sensitivity to interest rate changes, with longer bonds being more sensitive
Types of bonds compared
- are issued by national governments or their agencies (U.S. , notes, and bonds), generally considered low-risk investments
- are issued by companies to raise capital for various purposes, offer higher yields than government bonds but also carry higher risk, with the creditworthiness of the issuer affecting the bond's risk and
- are issued by state and local governments to fund public projects, often with exempt from federal and/or state taxes, resulting in generally lower yields than corporate bonds due to tax advantages
Bond prices vs yields
- Bond prices and yields have an inverse relationship: when bond prices rise, yields fall, and when bond prices fall, yields rise
- Factors affecting bond prices and yields include:
- Changes in interest rates cause bond prices to move in the opposite direction (rising rates lead to falling prices and vice versa)
- of the issuer impacts bond prices and yields (higher risk results in lower prices and higher yields, while lower risk leads to higher prices and lower yields)
- Time to maturity influences the sensitivity of bond prices to interest rate changes (longer maturities are more sensitive, shorter maturities are less sensitive)
- Investment decisions based on the inverse relationship between bond prices and yields involve:
- Buying bonds when interest rates are expected to fall, potentially leading to higher bond prices and capital gains
- Selling bonds when interest rates are expected to rise, potentially resulting in lower bond prices and capital losses
- Considering the investor's investment horizon and risk tolerance (longer-term investors may tolerate more , while shorter-term investors may prefer bonds with less )
- Evaluating the , which represents the total return anticipated on a bond if held until it matures
Special Bond Features
- allow the issuer to redeem the bond before maturity, typically when interest rates fall, potentially affecting the bond's yield and price
- Convertible bonds give bondholders the option to convert their bonds into a predetermined number of shares of the issuer's common stock, combining features of both debt and equity securities
Key Terms to Review (49)
Apple, Inc.: Apple, Inc. is a multinational technology company known for its innovative products such as the iPhone, MacBook, and Apple Watch. It is also one of the largest publicly traded companies by market capitalization.
Bennett: Bennett refers to a specific type of bond valuation model that emphasizes the relationship between bond prices and interest rates. It is used to understand how changes in market interest rates affect the value of bonds.
Bond price: Bond price is the present value of a bond's future interest payments and its maturity value, discounted at an appropriate interest rate. It reflects what investors are willing to pay for the bond in the market.
Callable Bonds: Callable bonds are a type of bond that allows the issuer to redeem the bond before its maturity date. This gives the issuer the option to repay the bond early, which can be advantageous if interest rates decline, allowing the issuer to refinance at a lower rate.
Capital gain yield: Capital gain yield is the price appreciation component of a stock's total return, calculated as the change in the stock's price divided by its initial price. It reflects how much an investment has grown in value over a specific period, excluding dividends.
City of Chicago: The City of Chicago is a major U.S. city that issues municipal bonds to finance public projects and infrastructure. These bonds are a form of debt obligation for the city, often evaluated by investors for their creditworthiness and yield potential.
Convertible Bonds: Convertible bonds are a type of corporate bond that can be converted into a predetermined number of the company's common stock shares at the option of the bondholder. This feature allows investors to potentially benefit from the appreciation of the underlying stock while still receiving the fixed income characteristics of a bond.
Corporate Bonds: Corporate bonds are debt securities issued by private corporations to raise capital for their operations, expansion, or other business activities. They represent a loan from investors to the issuing company, with the company agreeing to pay a specified interest rate and repay the principal amount at a future date.
Coupon payment: A coupon payment is the periodic interest payment made to bondholders during the life of the bond. It is usually expressed as a percentage of the face value of the bond.
Coupon Payment: A coupon payment refers to the periodic interest payment made by the issuer of a bond to the bond holder. It is the regular payment made by the bond issuer to the bondholder, typically on a semi-annual or annual basis, as compensation for the use of the bondholder's capital.
Coupon rate: The coupon rate is the annual interest rate paid by the bond issuer to the bondholder, expressed as a percentage of the bond's face value. It determines the periodic interest payments made to investors throughout the life of the bond.
Coupon Rate: The coupon rate is the annual interest rate paid on a bond, expressed as a percentage of the bond's face value. It represents the fixed amount of interest a bond issuer will pay to bondholders over the life of the bond. The coupon rate is a crucial factor in understanding the characteristics of bonds, their valuation, and their historical returns, as well as alternative sources of funds for organizations.
Credit risk: Credit risk is the possibility of a borrower failing to repay a loan or meet contractual obligations. It affects lenders and investors as it impacts the expected returns on investments involving debt instruments.
Credit Risk: Credit risk is the risk of loss arising from a borrower's failure to repay a loan or meet contractual obligations. It is a fundamental consideration in the context of bonds, trade credit, and receivables management, as it can significantly impact the value and performance of these financial instruments and transactions.
Deep discount bonds: Deep discount bonds are bonds sold at a significantly lower price than their face value, often below 80% of par. They offer higher returns through capital appreciation rather than interest income.
Default: Default occurs when a bond issuer fails to make the required interest payments or principal repayment on time. It signifies a breach of the bond's terms and can lead to severe financial consequences for both the issuer and bondholders.
Duration: Duration measures the sensitivity of a bond's price to changes in interest rates. It is expressed in years and indicates how long it takes for the price of a bond to be repaid by its internal cash flows.
Duration: Duration is a measure of the sensitivity of a bond's price to changes in interest rates. It represents the weighted average time to the receipt of all future cash flows from a bond, including the return of principal. Duration is a crucial concept in understanding the characteristics of bonds, their valuation, the yield curve, interest rate risks, and the historical returns of bonds.
Face Value: The face value, also known as the par value or nominal value, of a bond or other financial instrument is the amount of money that the issuer of the instrument promises to pay the holder at maturity. It is the stated value printed on the bond certificate and represents the amount the issuer will repay the bondholder when the bond matures.
Floating-rate bonds: Floating-rate bonds are debt securities with variable interest rates that adjust periodically based on a benchmark rate. These bonds help investors hedge against interest rate fluctuations.
Government Bonds: Government bonds are debt securities issued by a government to finance its operations and expenditures. They represent a loan from the investor to the government, with the government agreeing to pay the investor a fixed rate of interest over a specific period of time and to repay the principal amount at maturity.
Interest income: Interest income is the earnings generated from investments in bonds or other interest-bearing assets. It represents the return received by bondholders for lending their money to issuers.
Interest rate risk: Interest rate risk is the potential for investment losses due to fluctuations in interest rates. It primarily affects bonds and other fixed-income securities, as their values are inversely related to interest rate changes.
Interest Rate Risk: Interest rate risk refers to the potential for financial losses due to changes in the prevailing market interest rates. It is a critical concept in the context of various financial topics, including bond characteristics, bond valuation, yield curve analysis, interest rate and default risks, performance measurement, optimal capital structure, and interest rate risk management.
Junk bonds: Junk bonds are high-yield, high-risk securities typically issued by companies with lower credit ratings. They offer higher returns to compensate for the increased risk of default.
London Interbank Offered Rate (LIBOR): LIBOR is the average interest rate at which major global banks lend to one another in the international interbank market for short-term loans. It serves as a globally accepted key benchmark interest rate.
Maturity Date: The maturity date, also known as the redemption date, is the specific date when a bond or other debt instrument becomes due and the principal amount must be repaid to the investor. It marks the end of the bond's life cycle and the time when the issuer's obligation to the bondholder is fulfilled.
MoneyWeek: MoneyWeek is a weekly financial magazine that provides insights, analysis, and advice on personal finance, investments, and economic trends. It is widely read by investors and finance professionals for its in-depth coverage of market news and trends.
Municipal Bonds: Municipal bonds are debt securities issued by state and local governments to fund public projects and operations. They are considered relatively low-risk investments due to the taxing power and revenue sources of the issuing municipalities.
Municipal bonds (“munis”): Municipal bonds, or 'munis,' are debt securities issued by local governments, states, or municipalities to finance public projects. They offer tax advantages, often being exempt from federal income tax and sometimes state and local taxes as well.
Par value: Par value is the nominal or face value of a bond, typically $1,000, that indicates its maturity value and the amount to be paid back to the bondholder at maturity. It also serves as the basis for calculating interest payments on the bond.
Par Value: Par value is the nominal or face value of a bond, which is the amount the issuer promises to pay the bondholder at maturity. It is the value printed on the bond certificate and represents the amount the issuer will repay the investor when the bond matures.
Prime rate: The prime rate is the interest rate that commercial banks charge their most creditworthy customers, typically large corporations. It serves as a benchmark for various other interest rates including those for loans and mortgages.
Principal: The principal is the owner or shareholder in a corporation who delegates authority to agents (managers) to act on their behalf. Principals invest capital and expect returns, while ensuring that their interests are represented in corporate decisions.
Principal: The principal is the original amount of money borrowed or invested, excluding any interest or other charges. It is the core value upon which financial calculations and transactions are based, playing a crucial role in understanding loan amortization and the characteristics of bonds.
Savings bonds: Savings bonds are government-issued debt securities that earn interest over a specified period. They are considered low-risk investments and typically used for long-term savings goals.
Tennessee Energy: Tennessee Energy is a utility company that issues bonds to finance its operations. These bonds are debt securities that pay periodic interest and return the principal at maturity.
Treasury Bills: Treasury bills (T-bills) are short-term debt securities issued by the U.S. government with maturities of one year or less. They are considered one of the safest investments due to the full faith and credit backing of the U.S. government, and they play a crucial role in the functioning of financial markets and the broader economy.
Treasury bills (T-bills): Treasury bills (T-bills) are short-term debt securities issued by the U.S. Department of the Treasury with maturities ranging from a few days to 52 weeks. They are sold at a discount to their face value and do not pay periodic interest.
Treasury bonds: Treasury bonds (T-bonds) are long-term debt securities issued by the U.S. Department of the Treasury to support government spending. They have maturities greater than 10 years and pay periodic interest until maturity, at which point the principal is repaid.
Treasury Bonds: Treasury bonds are debt securities issued by the U.S. government to finance its operations and borrowing needs. They are considered one of the safest investments due to the full faith and credit backing of the U.S. government, and they play a crucial role in the U.S. financial markets and the historical returns of bonds.
Treasury notes: Treasury notes are U.S. government debt securities with maturities ranging from 2 to 10 years. They pay interest every six months until maturity, at which point the face value is returned to the holder.
Treasury Notes: Treasury notes are debt securities issued by the U.S. government with maturities ranging from 2 to 10 years. They are considered low-risk investments and are commonly used to finance the federal government's operations and borrowing needs.
US Treasury bills (T-bills): US Treasury bills (T-bills) are short-term government securities with maturities ranging from a few days to 52 weeks. They are sold at a discount from their face value and do not pay periodic interest.
US Treasury note rate: US Treasury note rate is the interest rate paid by the U.S. government on its intermediate-term debt securities, which have maturities ranging from 2 to 10 years. These rates serve as a benchmark for many other interest rates in the economy.
Yield: Yield is a measure of the return or income generated by a financial instrument, typically expressed as a percentage of the instrument's current price or face value. It is a crucial concept in the context of financial instruments, time value of money, and the characteristics of bonds.
Yield to Maturity: Yield to maturity (YTM) is the total return anticipated on a bond if the bond is held until it matures. It is the discount rate that makes the present value of all future coupon payments and the bond's par value at maturity equal to the bond's current market price. YTM is a key concept in understanding the time value of money, bond characteristics, bond valuation, interest rate risks, and the cost of capital.
Yield to maturity (YTM): Yield to maturity (YTM) is the total return anticipated on a bond if the bond is held until it matures. It is expressed as an annual percentage rate and takes into account the bond's current market price, par value, coupon interest rate, and time to maturity.
Zero-coupon bonds: Zero-coupon bonds are debt securities that do not pay periodic interest. Instead, they are issued at a discount to their face value and mature at par value, with the difference representing the accrued interest.